Random walk expectations and the forward discount puzzle
By: Philippe Bacchetta, Eric van Wincoop.
Contributors: Van Wincoop, Eric.; National Bureau of Economic Research.
Series: NBER working paper series -- no. 13205.; Working paper series (National Bureau of Economic Research) -- working paper no. 13205.
Publisher: National Bureau of Economic Research
Published: 2007
Place of publication: Cambridge, Mass
Language: eng
Number of pages: 13
Subjects: Random walks (Mathematics); Foreign exchange rates -- Econometric models; Interest rates
Description: "Two well-known, but seemingly contradictory, features of exchange rates are that they are close to a random walk while at the same time exchange rate changes are predictable by interest rate differentials. In this paper we investigate whether these two features of the data may in fact be related. In particular, we ask whether the predictability of exchange rates by interest differentials naturally results when participants in the FX market adopt random walk expectations. We find that random walk expectations can explain the forward discount puzzle, but only if FX portfolio positions are revised infrequently. In contrast, with frequent portfolio adjustment and random walk expectations, we find that high interest rate currencies depreciate much more than what UIP would predict."--Abstract.
Notes: "June 2007"

Includes bibliographical references (p. 9).

Also available in PDF from the NBER world wide web site (www.nber.org).